Construction Bonds

What is a bond?
A bond is a special form of contract whereby one party guarantees the
performance by another party of certain obligations. A bond is a contract,
and as such, is interpreted according to the rules of contract law.

KEY DISTINCTIONS: Must be in writing and must be the original to be

enforceable.

A bond may also be referred to as a “contract of suretyship”.

Who are the parties to the contract?

 the principal, the surety and the obligee
Who makes the promise?
 the surety

What does the surety promise?

 that the principal will perform its obligations

Who does the surety make the promise to?

 the obligee – because the obligations are owed to the
obligee
Three types of bonds are normally used on construction
projects:

1. Bid bonds
2. Performance bonds
3. Payment bonds

In the context of construction projects, the principal is

usually the contractor and the obligee is the project owner.

The purpose of a bond is to provide some protection to the

obligee, due to the risks inherent in the industry. If the
principal fails to perform, the obligee can look to the surety
to compensate for the loss or damage caused by the
principal.
Roles & Responsibilities
Surety
The surety guarantees the performance of another party.

Example 1: The surety guarantees the performance of a

contractor for the benefit of the owner of a project.

Examples 2: The surety guarantees the performance of a

subcontractor for the benefit of a contractor.

Principal
The principal pays the surety a fee/premium, and in exchange,
the surety accepts the obligations to guarantee the performance
of the principal.
How is a bond created?

Two separate agreements are made when a bond is issued:

1. Principal & Obligee

The principal enters into a contract with the obligee. For
example, a contractor enters into a contract with an owner to
renovate a building by June 2014.

2. Principal & Surety

The principal pays a premium to the surety, and in exchange,
the surety guarantees performance by the principal. For
example, a bonding company issues a bond for the
contractor’s obligations as set out in its contract with the
owner.
Indemnities & Other Surety Recourses

Where a surety has paid out money to satisfy the principal’s

obligations, it is subrogated to the rights of the obligee.

Subrogation allows the party who pays for a loss suffered by

another party to assume the rights of that other party for the
purpose of recovering that loss from a third party.

The contractor fails to perform its obligations under its

contract with the owner.
As a result, the owner suffers a loss and calls on the bond.
The surety pays out to the owner on the bond.
The surety then has a right of subrogation and can sue the
contractor to recover the amount paid out.
Bid Bonds
Invitations for a bid usually require that the bid be accompanied
by a bid bond in the amount of 10% of the amount of the bid.

A bid bond is a guarantee by a surety, for the benefit of a project

owner, that if the owner accepts a bid by the contractor in
question, and the contractor fails to enter into the contract, the
surety will pay the penalty specified in the bond.
Performance Bonds
In the construction industry, a performance bond is a bond
under which the surety guarantees a contractor’s performance
of a construction contract.

On large construction projects, the prime contractor often

requires its major subcontractors to provide performance
bonds. If a subcontractor provides the bond, the prime
contractor is the obligee and the subcontractor is the
principal.
Performance Bonds (continued…)
Performance bonds can have any face value, but they are
usually issued in an amount equal to 50% of the value of
the construction contract.
This is the face value of the bond, and is the maximum
potential liability of the surety in almost all cases.

The construction contract is incorporated by reference into

the bond.
Once the surety has been put on notice that its principal is in default, it
generally has six options:

1. It can have the principal remedy the default by performing its obligations.

2. It can complete the contract itself in accordance with its terms and conditions.

3. It can solicit bids for completion of the work and pay the obligee the difference
between the accepted bid and the remainder owing to the principal under the original
contract, up to the face value of the bond.

4. It can pay the obligee the amount of the bond.

5. It can assert a defence and refuse to do anything.

6. If there is a genuine dispute between the obligee and the principal, it can take a “wait
and see” approach to determine whether the principal is in default.
Defences under a Performance Bond
The surety’s obligations and the obligee’s right to demand
payment are triggered only when the principal defaults on its
obligations.

When a claim is made by the obligee, the surety is entitled to raise

defences.

For example, if the principal is able to raise a defence that the

main contract is unenforceable, based on misrepresentation,
frustration or lack of consideration, the surety can avail itself of
that defence as well.
Payment Bonds
A payment bond is a guarantee of the performance of a
payment obligation. A party to a contract may require a
payment bond when there is a concern that the other party
may default on a payment obligation.

For example, owners and general contractors sometimes

require a labour and material payment bond to protect
against liens by unpaid subcontractors, suppliers, and others
working below them in the contractual chain.